The Top Five Accounting Mistakes Analysts Make

Prior to entering graduate school almost 20 years ago, I had a very important phone conversation with an analyst at the Dreyfus Founders Funds, Chuck Reed. That brief phone conversation changed my focus in graduate school — and hence my life. One of the questions I asked Chuck was, “What skills should I acquire that most analysts overlook?” He answered unequivocally, saying, “Most analysts do not understand accounting.”

Shocking as it may seem, I still believe Reed’s two-decade old admonishment to me remains true, even despite the emphasis made by CFA Institute in its CFA charter program. Here are what I believe are the top five accounting mistakes analysts make:

1. Using Generalized Financial Statements

If analysts take the time to actually read financial statements — and I think that few of them actually do — it is likely that they digest them through a third-party provider, such as Bloomberg, FactSet, S&P Capital IQ, Reuters, Yahoo! Finance, etc. The problem with this approach is that each of these services modifies each company’s unique financial statements to fit into a pre-created template. These services do this to ensure comparability across companies, industries, and nations.

However, I would argue that the generalization of these financial statements obscures as much as it reveals. An example is the compressing of one-time items into a single line item which hides the fact that some companies have many more one-time items each year than do other companies. If a company has five “one-time” items each year, as compared with others in its industry that may have infrequent “one-time” items, this is a sign of poor accounting standards or abuses of management accounting discretion and is valuable information about company character.

Additionally, the smearing of categories also hides the unique voice of the CFO, the auditor, and others within the organization who prepare financial statements. Knowing that some companies report a bland “net revenues” while others report “customer sales” tells you something about the culture of the organization. Taken individually, these differences seem inconsequential, but taken as a whole, the financial statements tell you a lot about the culture of a company you may invest in.

Ideally, the unmodified financial statements are examined, and the amounts reported in these statements are matched to the specific narrative of the business as revealed in the management’s discussion and analysis section. Are the two stories — the quantitative and the qualitative — consistent? They better be!

I once caught an arithmetic error in the calculation of gross profit of a huge multi-billion dollar company. I caught this because I was following the numerical narrative of the statements. That I could not get the third number down in the income statement, and the first actual real calculation, to match what they reported was telling. According to their investor relations pro, I was the only analyst to catch this multi-million dollar reporting error on their part; and in fact, the statistical agencies simply had entered the numbers from the statements directly!

2. Not Understanding the Reflexivity/Interactivity of the Three Major Financial Statements

In my experience, few analysts take the time to trace a dollar of capital raised within a company (as shown on the balance sheet) through the income statement, to the bottom line, and then back to the balance sheet again. Nor do they relate changes in the balance sheet accounts to the cash-flow statement to identify huge inconsistencies in either amounts or categorizations. Instead, most analysts analyze the statements in isolation from one another.

A brief example is that few analysts understand in what way a change in accrued liabilities affects operating expenses on the income statement, and, in turn, how this affects cash flows from operations. Ditto for income taxes payable, short-term notes payable, long-term notes payable, and so forth.

Yet, when you trace a unit of capital (rupees, yuan, yen, dollars, euros) through the financial statements, you once more get a sense of how straightforward and how consistent the financial reporting is at a business. This, in turn, is indicative of the character of the people that run the organization.

I once caught a company whose operating cash flows dramatically did not match the number that could be gleaned by doing a comparable calculation using balance sheet numbers to calculate the same! Only by understanding the interactivity of the statements did I catch this error/possible fraud.

3. Not Creating Apples-to-Apples Comparisons in Time

This particular accounting secret is one that I have never discussed publicly. However, understanding this was one of the secrets to my success as a portfolio manager. Specifically, have you ever noticed that the temporal dimension for the income statement, balance sheet, and cash-flow statement are all different?

The income statement is reported quarterly for the first three quarters of the year and then annually, whereas the balance sheet is always reported as a quarterly snapshot — even when it is the fourth quarter. Last, the cash-flow statement is always shown as an amassing of cumulative cash for the year. Each of these is very different from one another, and they only align in the first quarter for any company.

In my experience, companies play games with these time dimension mismatches. Consequently, analysts must put all of the financial statements on the same temporal dimension. I put each of the financial statements of the companies I examine on both a quarterly and annual basis. This means that you must create a fourth quarter income statement by subtracting the first three quarters of the year from the annual income statement. This also means that you must subtract the first quarter cash-flow statement from the second quarter’s, the first two quarters’ from the third quarter’s, and the first three quarters’ from the annual number. When you do this, you can see some of the games companies play.

I once caught a company delaying a payment on a massive capital lease so that the company could report positive operating cash flow in its first quarter. In the second quarter, the operating cash flow barely changed even though it was a steady cash-flow-generating business. The reason was that the second quarter cash-flow statement included the massive lease payment. Only by creating quarterly cash-flow statements could I readily see that they did not match my narrative understanding of how the business should work.

4. Not Adjusting Statements for Distortions

This is a classic problem in financial statement analysis. Despite this fact, most analysts do not modify financial statements to adjust for one-time items, including write-offs, sales of divisions, accounting revisions, and so forth. Exactly what to look for is outside the scope of this post, but most analysts simply do not take the time to do this.

As a brief tip, if you ever see a write-off number that is a bit too round, such as ¥500 million or €75 million, you can bet that the amount is management’s estimate of a loss and not the actual loss. Therefore, you can expect future corrections to this initial write-off estimate.

5. Not Reading the Footnotes

Last, despite all of the warnings to pay attention to the information contained in footnotes, most analysts do not read them. Nor do most analysts take the numbers from the footnotes and put them into the main three financial statements.

An example of this would be to take the detailed property, plant, and equipment figures reported in the footnotes and incorporate these into the analysis of the entire balance sheet. I once caught a company that clearly was playing games with its useful expected lives figure because when I looked at the common-size over assets financial ratios, I could see that one of their property, plant, and equipment numbers had gone down massively on a relative basis. This distortion, in turn, had big ramifications for the reported depreciation and hence net income, operating cash flow, and free cash flow.

While there are many other accounting mistakes analysts make, if you correct those I have highlighted above, I believe you will successfully separate yourself from your analyst peers and improve your returns.

All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Jason Voss, CFA, tirelessly focuses on improving the ability of investors to better serve end clients. He is the author of the Foreword Reviews Business Book of the Year Finalist, The Intuitive Investor. Previously, Jason was a portfolio manager at Davis Selected Advisers, L.P., where he co-managed the Davis Appreciation and Income Fund to noteworthy returns. He holds a BA in economics and an MBA in finance and accounting from the University of Colorado.

Ethics Statement

My statement of ethics is very simple, really: I treat others as I would like to be treated. In my opinion, all systems of ethics distill to this simple statement. If you believe I have deviated from this standard, I would love to hear from you: jason@jasonapollovoss.com

I think one reason why so many buy-side analysts (and I think it’s more of an issue on the buy-side) use generalized financial statement is that it’s easy – far easier than having to maintain your own spreadsheet models that integrate the income statement, balance sheet and cash flow for a relatively large number of companies that either are in a portfolio or of interest.

One solution to this issue would be to use technology to make use of the XBRL-tagged data from the EDGAR database. Building a generic income statement, balance sheet and cash flow model and making tweaks to it for a specific company or industry isn’t rocket science. Manually gathering the data for it, however, is a time consuming chore. However, there isn’t freely available software that would automate the capture of XBRL-tagged data from the EDGAR database and then put it into whatever model an analyst might want to construct. The SEC punted on spending the money to develop such a tool for automated data extraction, which is one reason XBRL-tagged data is grossly underutilized.

If buy-side analysts and portfolio managers could automate the process of pulling actual, company-by-company results into a spreadsheet model, they would find it relatively easy to address each of the issues you raise here.

I love your XBRL suggestion. Take a look at my interview with the brains behind Thinknum from 2014. They are doing many brilliant things with the power of XBRL. Also, though it is still in the testing phase, IRIS in India, is making the most spectacular XBRL-driven analytical platform I have seen.

Thanks, Jason, but – unless I’m missing something – neither of these does what the instigators of XBRL had in mind. Namely, to give anyone the ability to freely and easily consume the financial statements in the EDGAR database. In other words, to construct a model in a spreadsheet with pointers to a specific taxonomic element (or combination of elements) within a filing for a defined time dimension (a period or date) along with the ability to derive values (for example, the ratios, margins or the sort of triangulations between financial statements you describe). Today, if I want to pull numbers from EDGAR, I’m pretty much doing what I did 20 years ago: copying and pasting from an HTML document into a spreadsheet where the main value is ensuring the numbers in my model are exactly what was published. This is still time consuming an tedious.

I think you may be missing something. Take a look at the subscriber options at Thinknum, for example, and not the free options. Separately, the IRIS platform I referred to is a piece of software of which I received a sneak preview. It will do exactly what you are asking about and way, way, way more. It is the most powerful piece of software I have ever seen for financial professionals. You can find out more at http://www.irisbusiness.com I think you will be quite pleased.

I strongly second the idea of making XBRL data available. I have tried to find out how to access this data without success – except to learn you need to purchase special software.

The concept of the Thinknum site is excellent, but …. For the life of me I cannot figure out how to use it. (And I think I am at least normally intelligent). And the line items they offer are just the same summary metrics complained about in the first point here.

You might let your readers know that many of those databases include data sets that allow the users to download “reported” financial statements which is what I use. Databases such as SNL required you to toggle to this dataset and many analyst don’t know it exists.

Jason,
As always, an excellent write-up!
Let me add a few areas where analysts ignore, either because they don’t understand them or assume that these items don’t matter, supposedly in the larger scheme of things
1. Restructuring cost – What is being lumped together in restructuring costs line item?
2. Deferred costs – Are companies delaying recognition of deferred tax assets or opportunistically hurry in recognizing them?
3. Audit qualifications – Most analysts assume auditors don’t write anything worthy in the audit reports.

I just want to draw your attention to new audit reports effective for 2016 audits from the international perspective. Here is a link to the blog I wrote in case you have an interest– hopefully analysts will get more information.

Thanks Jason. Just one correction, I meant deferred taxes (not costs). Also to add, the adjustments to operating profit (removing one-offs) is increasingly being skipped by analysts on the pretext that they don’t add-up to significant amounts (they don’t move the needle much). But then analysts are always going to miss out on qualitative aspects of the biz if they don’t attempt to make adjustments. Because in the process of making adjustments you are ‘forced’ to dissect the notes and amounts and discover new things.

Right on! Yes, I agree fully with Jason. I have an accounting background and it has definitely been a huge resource of knowledge in my career as an analyst.

My input for the cure for #2: Get an accountant to give you two successive trial balances. Don’t leave your desk until you can create a set of financials where the cash on your balance sheet foots to the second period’s ending cash balance. If you can do that, you’ve got about 90% of GAAP.

Brilliant write up. Truly harmonizing accounting knowledge with financial statement analysis. May like to add on a couple of things here:

1. Accounts receivable/Accounts payable quarter on quarter movement – Never underestimate the AR/AP line. Cash flow drives company operations and while having a large AR beefs up your assets on the balance sheet you might wonder whether the company is doing a good job of recovering the receivables. Similarly I had seen nice balance sheets but really ugly looking cash flow statements when doing stock picks.

2. Other operating expenses/Admin and general expenses – Explore this line as a proportion of your total expenses. Not a standard guideline but if this line is exceeding 30% you might be wondering of the glorious items parked in this financial statement line item.

3. Accounting for investments (in a subsidiary/JV/associate/financial instruments) – Too often I have seen companies getting a little too creative with the accounting under FRS 39 and some analysts not even knowing the difference between the accounting treatment between a subsidiary and an associate. As an analyst it will not do some harm in reading the FRS 39 literature in understanding the 4 basic financial instrument asset classes.

I like all of your amendments to the post…now folks have a veritable mini-accounting course available in the post and its comments. Thank you for taking the time to organize and share your thoughts with the readers.

Regarding Accounting for Investments, I am going to assume subsidiary = significant influence in company ( > 50%), leading to consolidated financial statements; Therefore, a major part of the operating activities of the firm ( I mean that both on a numbers basis and in intrinsically speaking).

However, Investment in Associate ( non-core/non-operating income), is accounted either by the Cost Method or Equity Method.

Cost Method ( dividend income) Equity Method ( receive % income)….When doing comparable company analysis of firms in same industry, I always wondered whether I should deduct for exampel the equity method income out of net income…..as an adjustment to Net Income….same way you would adjust for a non-recurring gain on sale asset / expense……

I understand it is recurring and it is ultimately income attributable to shareholders, but I find it “possibly” inappropriate to compare 1 company to others in same industry that do not have investments in associates? Any thoughts?

However, for multiples such as Equity Value / Net Income….equity value comes from share price , which investors have determined is fair based on all income attributable to shareholders , which includes these associate investments..Therefore, would that make my entire idea inappropriate.

Thank you so much for your thoughtful question, and for reading the article so carefully!

To me the denominator in evaluating a prospective business for purchase (whatever the security they are offering: debt, preferred, convertible, equity, et. al.) is the quality of a management team’s ability to invest capital. Ideally you have a numerator that is returns on capital and a denominator that is total capital. Navigating to this equation for all prospective investments is, to me, what makes businesses comparable. How a management team does this over time, and an evaluation of their ideas for how to invest capital in future capital-generating projects, is the only other quantitative ingredient. The qualitative ingredients are many, but their ethics and transparency are paramount to me.

As for using multiples…my first step would be to make the adjustments to financial statements necessary to make clear the returns on capital, as described above. If there is only a slight difference in the returns on capital of different firms, but very different multiples, then this is one way of evaluating the sophistication of an industry’s investors. If there are limited differences in returns on capital and future prospects, but the multiples (P/E, P/BV, P/EBITDA, et. al.) then it likely means that the industry’s investors are not doing their homework.

Wow, what a heartfelt message! Our subscription service does not provide a ‘follow an author’ option. However, you may subscribe to The Enterprising Investor, which is published at least once every business day. To do so look for the link at the bottom of any of our articles.

Separately, I have not written about accounting much over the years because I consider it a secret source of alpha-generation. But I may consider sharing more secrets going forward.

In the meantime, I hope that my, and my colleagues’ writings become a part of your daily routine.

Yours, in service,

Jason

PS – Was just in South Africa in April and loved it. Sorry that I missed you.

And, I completely agree with you on accounting analysis being a secret source of alpha generation. I have been using it all along. If I want to have a refresher course, it would be on accounting.

In fact, I would like the CFA Institute to offer interested charter holders a complementary book based on the latest accounting analysis sections being taught to current candidates.

In my experience, this is so because the entire process is tedious and can be thought to be akin to value investing, which is also a tedious process. I think not many people are, psychologically, able to yield to the demands of time and labour needed for both.

As Seth Klarman wrote in his seminal book on value investing – and I paraphrase – there is nothing new in this book but it’s unlikely to be followed by a large section of investors due to innate human nature.

I suspect a similar outcome for accounting analysis emphasis in one’s investment analysis.

Based on my current limited understanding of human behaviour, I may sound pessimistic and I would live to be proved wrong.

The other interesting thing about Seth Klarman’s book, of course, is its tremendously high after-market sales price. It seems there is a bubble in the price of that value investor’s book : ) Hopefully that means that many who are willing to pay over US$1,000 are more inclined to implement the book’s ‘secrets.’

Finally, I hope we have made you a fan of The Enterprising Investor – we would love to have you as a subscriber!

Fantastic article and comments. I would love to see some real examples of these. If you and everyone who provided a tip in the comments were to put some real world examples together, this could be a really neat mini-course.

Hi, nice article indeed !
I am not an analysts so Just wondering if the analysts do not concentrate on these important aspect then what they concentrate on 🙂
Cash flow is such an important tool to measure companies cash generating abilities from operating activities which will indicate if the business is performing well as cash generated from investing & financial activities do not give clear picture if we are looking for consistency & cash generating abilities in future.
Also wanted to know your opinion about reclassification of assets and liabilities in balance sheet. For e.g sometimes company try to push current liabilities into non current liabilities to show better liquidity ratio. Specially those unsecured loan from various parties but it is not possible to know detail about those loans from BS unless you are looking into the corresponding notes.Do you give importance to this area?

Hello Pa
Yes, cash flow from operations over the length of your investment time-horizon is one of the keys to investment success.

In answer to your question, yes, I have seen companies try and classify short-term liabilities as long-term liabilities in order to improve liquidity ratios. The list of accounting abuses, is, unfortunately, a long one. However, I have to say that in my career the number of companies engaged in accounting gimickry is pretty low. I would say around 5%. However, as a caveat, my experience is limited to the United States, Canada, Brazil, Australia, New Zealand, and China. I have not done much exploration outside of those countries.

hi Jason. I like your article. I’m a 22 year old Accounting graduate and I aspire to be a CFA. I did learn a lot. I just wish I could get a job now especially in the investment companies where I believe I can be able to learn more.

Thank you for your comment. Yes, getting a job in finance is extremely challenging. Take a look at my post called, “Advice on How to Become a Research Analyst” as it may help you in your job search. Also take the time to read through the comments because they contain a lot of valuable information, too.

Hello Jason
Thank you for another excellent post, especially for folks like me who cringe at the thought of financial statements.
I can add very little to the many thoughtful comments you have received for this post, except your insightful suggestion to me on the subject of stakeholders.
From memory, you had suggested that one should keep in mind all the stakeholders in the business as you go down the income statement.
I have found this to be a worthwhile, thought provoking exercise.
I cannot recall if your readers added this, but in the case of US listed companies I would also recommend reading the 10-K – you have also mentioned this in your book.
Best wishes
Savio

I am humbled by your continued interest in the things I write. Thank you for always taking the time out to share your views – even when we disagree : ) – about what I write.

So that folks reading the comment stream understand what I had communicated about the income statement, let me add a wee bit of detail. When I read the income statement I read it as a reporting of payment to stakeholders. I believe that the order of these payments is very telling, but others do disagree with me : ) At the very top you have a payment to the business by customers in the form revenues; at cost of goods sold you have a payment to suppliers; at the sales, general, and administrative line you have a payment to employees and PR/marketing folks; at the research and development line you have a payment to the teams charged with growing the top line in the future; at the interest expense level you have payments to debt holders; at the income tax expense level a payment to governments; and then to shareholders. In short, management engages in a very difficult task of balancing these many stakeholders’ interests. If you try and increase shareholder value by squeezing suppliers they may stop doing business with you and can interrupt your supply chains. If you try and lower the quality of your products customers may stop paying the company revenues. And so forth. Management cannot get away with too much pressure on any of the line items for long, else they destroy the value of the operating model.

Thanks for this great article!
Totally agree with you.
I will share it with my students to reinforce the importance of accounting : I lecture in financial analysis, international accounting, advanced financial statement analysis.

In addition to what you say very few financial analysts understand pensions, they do not even mention it as a risk whereas it is material for many companies and most plans are underfunded!
And very few make comments on Deferred Tax assets as well.

Yes, there are all kinds of nasty little manipulations of financial statements that take place. Thank you for highlighting two additional ones. Thankfully with the decline of the defined benefit pension plan, the mussing around with rate of return assumptions, smoothing, and other such stuff, affects a smaller proportion of the equity universe. Deferred tax assets…don’t even get me started : )

Glad that you enjoyed the piece…I hope we can win your continued advocacy.

Great piece of work written by u. Just want to share some thing ,
An analyst is the care taker of third party money. He must able to work like a legal hacker who is searching intentional errors done by other along with if he need to commit fraud how would he/ she do it…. Basically u r clever enough to spot out things..

We at calcbench couldn’t agree more with your conclusions. We’ve done a tremendous amount of work in the space. All of our focus is on XBRL based analytics. Our users can access the footnotes and drill into them and get actionable insights out. Here are two examples:

1. Pick the operating leases report from our research page (published May 2015)

Love it! I suppose if we actively manage money we should all be delighted with these inefficiencies. But somehow the part of me that became an analyst/PM because of my pursuit of the true state of the world is still offended.

Further to your first point about ‘mediated’ financials. I have tried downloading them into my own spreadsheets and found that many income statement line items have the wrong + or -. And it is not as if that is just an error in the title, because the error is sometimes there and sometimes not. The numbers add up correctly sometime, but other times not.

How on earth can you make any analysis of a company’s results if you are using a +number that should be a -number?

Nice article. By the way, significant portion of approaches mentioned routinely used by careful auditors so it sounds a little bit as a double check (which may be useful but not particularly efficient).

This blogpost made me buy your book. I’m an accounting doctoral student, soon to be assistant professor, and “understanding information” is the main message I try to pass on to my students in class. Thanks for all the insights into the investment world!

Good news to be reading this morning! Thank you for your endorsement. You may also like my series of posts entitled, “Skills That Separate You as an Investment Manager.” There are 10 in the series and aspiring analysts, in particular, may benefit.

This is a great article. However, I am a bit confused on Capital lease treatment.
Isn’t this the case – INterest portion of the Capital lease is accounted in operating cash flows and Principal portion is recorded in financing cash flows. These sound fair to me.

But, i think I am missing something from the statement around treating capital lease payments in Investing activities. Can you please help me understanding this?

Thanks for your kind words. I really appreciate you taking the time to share your thoughts, and your question.

I believe you are referring to #3 in my article and my example about the company that delayed a payment on a massive capital lease. Yes? If so, I believe I may have miscommunicated my point in the article. In this instance, the company was accounting for their capital lease obligations correctly. However, they delayed a payment on their lease by one day, paying the lease obligation on 1 April, rather than 31 March. By delaying payment by one day their operating cash flow looked positive when, in fact, it was negative for the first quarter. I caught the error because the company’s business model is one of steady cash flow generation. But in the second quarter cash flow statement, with an execution of the same business model, operating cash flow was barely higher than in the first quarter. This made no sense, so I called the company to try and understand what happened. After 3-weeks of back and forth they admitted they delayed payment on the lease to show a positive operating cash flow in the first quarter. This is highly unethical. So I sold my interest in the company.

I enjoyed reading your article. I agree with you that accounting is a necessary skill for analysts, which is why my first profession was in accounting even though I wanted to be an equity analyst. However, after spending 5 years in accounting, getting a CFA and an MBA, I found that I was pigeon-holed to always be an accountant. I found this has also be true for other accountant I met as well. Thus, when college students ask me whether they should go into accounting for a couple of years before jumping over to finance, I always say no.

I am sorry that has been your experience. At Davis Selected Advisers, where I worked, we actually hired an analyst because they started their career as an accountant. We wanted someone expert in accounting. However, I agree with you that people in the investment business are remarkably narrow-minded and unimaginative.

Many thanks, Jason, that was a really valuable article and much appreciated.

Just because my expertise is in derivatives/structured products and the accounting impacts of these can be a major component of the statements, even for non financial services companies, I would love to know if you have specific words of wisdom here too.

One thing I would like to add to your article and the string of excellent email responses is the value of looking (and thinking!) carefully about the Risk Factors section in a recent securites prospectus or 10K. The numbers contained in financial statements are, of course, very important but we should never lose sight of the fact that they are a numerical summary of “real” things that are happening to a company in its business. As a manufacturing company simplistic example, it is buying real things, making real things and selling real things: it is not buying, making and selling financial statement numbers, those are a numerical reflection of what it does. In the course of doing these real things, it runs risks — things related to its core business, as well as those that relate to its financial picture. When we look at the Risk Factors section (above), we see that, out of 30 or so, 27 (e.g.,) are completely generic and applicable to any company (e.g., the risk of competition!), while 3 or so are very specific to that company, what it does and how it does what it does. For example, a pharmaceutical company has a contract with a university to conduct drug research and the continued existence of that contract is a critical risk to the company. Without a pipeline of new patents, it will ultimately die when its existing patents lose their patent protection and generic copies are made. How does the company (could the company) protect itself against that risk? It is well worth spending significant time on Risk Factors, pulling out those that are specific to the company and thinking carefully about their implications.

What a great response! You have certainly contributed meaningful thoughts to the discussion; thank you.

The ‘Risk Factors’ section of the 10K is one of my very favorite pieces of regulation ever passed by legislators. I found it to be critical to my success as a portfolio manager. Yes, it is true, that the categories are boiler plate, but often the specific disclosures within those boiler plate categories was, in my experience, specific to the company. I was a generalist analyst and when I would pick up a 10K for a company in an industry I had never analyzed before, the risk factors section taught me a lot about what things to pay attention to in my further researches. Also, because the risk factors section could be renamed the ‘opening ourselves up to legal liability’ section and was written by litigation-averse legal staffs, I found it an insightful section. Yet, most analysts do not read the risk factors…mostly because they do not read 10Ks. Or if they do read 10Ks they focus on the financial statements only. As an aside, the section I found almost completely useless was the MD&A section where usually absolutely nothing of substance was disclosed. However, that said, when there was good disclosure there it indicated to me a higher quality/more honest management team. I would read the risk factors and use it as the springboard into examining the disclosed issues more in-depth and without the anesthetized language of a company’s legal team.

As for the derivatives section…that is a tough question and it dovetails with the entire “fair value” discussion, which spans more asset classes than just derivatives. My opinion there is that companies should be required to use standardized derivatives pricing models across the entire portfolio, across businesses, and across industries for disclosure. Perhaps even use multiple models for purposes of disclosure so that companies do not manipulate inputs to generate favorable appearances. All inputs need to be disclosed, including volatility, and with a justification for why those measures were chosen. Last, and this is most important, businesses should be required to report, not just end of period values, but also average values for the entirety of the period, and the range of values for the period. Too often financial firms window dress their balance sheets for end of period reporting while flaunting the lack of intraperiod disclosure. Ugh! If firms were required to quote the average values of these instruments, as well as the range of values, a lot of the b.s. would disappear. I would love to hear your thoughts on this Nick.

It sounds like you enjoyed the post; thanks! Yes, some of these things are (unfortunately) basic. I hope that analysts begin to dive deeper into the accounting. However, when portfolio turnover ratios are as high as they are there is not much time to actually read the official documents.

First, you need to decide which time period serves as the basis for the transformation. Do you want to put each of the statements on a quarterly basis, or on an annual basis, or some other time period. My preference is for quarterly statements. For the income statement, in the fourth quarter, it is reported on an annual basis and not a quarterly basis. So you have to take the annual income statement and subtract the sum totals for the first three quarters: Annual income statement – (Q1 + Q2 + Q3 income statements) = Q4 income statement. The balance sheet is always reported as a snapshot of the quarter end so no transformation needs to be done. Cash flow statements are reported on a cumulative basis always. For example, the second quarter cash flow statement actually shows cash flow totals for the first six months. To create a Q2 cash flow statement = first six months cash flow statement – Q1 cash flow statement. To create a Q3 cash flow statement = first nine months cash flow – (Q1 + Q2 cash flow statements). To create a Q4 cash flow statement = twelve months cash flow statement – (Q1 + Q2 + Q3 cash flow statements).

This is a great post and I especially like your point #3. I’m creating a quarterly look now for a company I’m analyzing and while tedious, I think it’ll be worthwhile to garner insight into seasonality and/or large accrual entries within particular quarters. This is a time-consuming process right? I know Excel Boost has an SEC Filings Wizard that makes importing SEC numbers into Excel easier but only for the latest FY. In your experience, have you found any shortcuts or is there no getting around the extra leg work.

First, nice to hear from you. I hope things in Colorado are wonderful.

Second, in answer to your excellent question. I am not sure what you mean by time consuming. Do you mean did it take minutes-hours-days-weeks to create the quarterly statements? Not sure which time scale you meant. For me, for each company I followed it took a once-per-quarter update of about 20 minutes in an Excel worksheet within a workbook. The creation of that worksheet took about 5-10 minutes at the outset. However, I am wicked-crazy-fast with Excel shortcut keys, and know how Excel works at a high-level. So my time investment was pretty minimal once the initial, normal, non-quarterly time scale spreadsheet was created. So the shortcut here is to create a copy of your normal, non-quarterly time scale worksheet and then copy your columns over to the total quarters you are wanting to examine (for 5 years, you would have to create 15 additional columns). If you do this cleverly by inserting your new columns in the middle of the existing columns then any ranges you have already created in formulas should retain. I hope that makes sense.

Yes I should have been more specific. I set up the historical financial statements in Excel for a company for 3 years by quarter for the I/S, B/S, and CF/S. Once I’m in Excel, I’m very quick. Taking the time to bring the data into Excel either by pasting or typing was the time-consuming part. I learned along the way that text in PDF can be copied while maintaining the text format which helped with the pasting of values into Excel. I just wondered if there was a quicker way to transfer the info from the SEC filings to Excel. But maybe not. Either way, I can see the value of laying out the financials by quarter already. I suppose I could exercise some patience 😉

One of my favorite articles in the site so far. It took me years to figure out many of these points, and they all massively improved my analysis abilities. I remember the first time I found discrepancies on one of the mentioned third-party provider sites when comparing the numbers to the 10-K report while doing a project for graduate school. Thanks for the great article!

Hi Jason,
The main reason in using a generalized financial statements which is provided by third-party data analytics providers is that the competition among these organizations to cater the needs of the customers within the mentioned delivery time.So for obvious reasons they collect those data items which the customer focuses on. An analyst has to learn the significance of other given elements also in the financial statements.

Thanks for the great article! I really enjoyed it. I really want to learn more about accounting and how it is applied to financial statements. Are there any masters programs in accounting that you would recommend?

Thank you for your praise of the piece. Regarding accounting programs…I think it depends on many different things, especially, a) what you are trying to accomplish by studying accounting; and b) where you live. In talking with accountants over the years most confess that they cannot understand the perspective of analysts wanting to extract information from financial statements. Most accounting programs spend a lot of time defining terms and teaching techniques for recording transactions. What you need instead is a criminal’s mind set when you learn this kind of information. Namely, “How do I alter this income statement item to ensure our profit target is met so I get my annual bonus so my spouse will stop bickering me about that vacation property?” Few accounting professors go into that territory. If I were in your shoes I would look to simply take a course in forensic accounting, or to read any one of the excellent books on financial statement analysis. My favorite is: “How to Read a Financial Report” by John Tracy.

Obvious many accounting knowledge contributors. I’m interested retail type who would like to become more versed in said, and would appreciate resource recommendations to accomplish?? Any suggestions, thanks ahead. Jason, I’ll acquire John Tracy book touted.

This is honestly one of the most useful posts about analysis that I’ve ever read. At the time of publishing I read it and decided to start putting it into action, months later I’m reaping the benefits and I can really see the improvement in the quality of my analysis.

That stands as the highest praise I have ever received for an article – thank you! I am very pleased that the information proved useful and that has helped to improve the quality of your analysis. Yea!

I received a question via Twitter that I am going to answer here. Matthew Griffith asked me to expand point #2. Here goes:

One dollar of capital raised on the liabilities side of the balance sheet becomes a dollar of assets, also on the balance sheet. Then it hops to the income statement and makes its way down to profits as each constituent with a claim to the business gets paid: customers receive a product (i.e. cost of goods sold), employees get paid, advertisers get paid, the research department gets paid, then debt holders get paid, then tax and regulatory authorities, then shareholders. Anything leftover makes its way back to the liabilities side of the balance sheet as retained earnings.

Next, the cash flow statements accounts are the net changes of balance sheet accounts, roughly speaking. In practice it never quite is exactly the same. For example, the net change in receivables on the balance sheet ought to be represented in the operating cash flow portion of the cash flow statement. If there is a huge disparity this is reason to talk with management.

Each of the statements serves as a check and balance on the other and an understanding of this reflexivity helps you to understand: a) the mechanics of the business itself, that is, how they make their money; b) the culture of the company’s finance and accounting function, which is more obvious when compared with a firm’s competition; and c) if fraud or a big stretching of the truth is taking place.

Your first point about using normalized data is very well said. Using the wrong normalized dataset can be a costly decision. Some datasets simply lump non-recurring and special charges into other operating expenses which provides no way for the analyst to assess nature of these charges. For that reason we’ve designed our TagniFi Fundamentals dataset to accommodate both non-recurring and special charges as separate line items.

Second, we’ve taken a hybrid approach with our normalized data by exposing the as-reported items used to arrive at the normalized value. For example, if we’ve mapped three line items into other operating expenses the analyst could review this detail by right-clicking on that cell of the spreadsheet to see the name and amount of each item. We believe this provides the best of both worlds since you can use normalized data yet see the as-reported detail when desired.

Lastly, normalized data will actually make points 2, 3 and 4 in your article much easier. For example, you can build an excel model to look at the quarterly cash flow statements instead of the year-to-date data that most companies report. This will make it much make it easier to see irregularities similar to the examples you’ve mentioned.

Normalized data can be an analyst’s best friend, allowing her to cover hundreds or thousands of companies in the same time it takes to manually collect data for a single company. Using the right normalized dataset is the key to avoiding many of the mistakes you’ve outlined in this excellent post.

Thank you for including details about TagniFi’s offerings. I am a strong advocate for analysts using primary data, but also being able to take advantage of modern computing to assess many more companies than normally possible. It sounds as if your offering combines the best of both worlds. Well done!

Thanks for the excellent summary. I will share it with my finance and accounting students who will be taking my courses on financial analysis and valuation at the Singapore Management University.

Frankly all the points you mentioned in the post are in my course curriculum (and I believe accounting/finance professors at many other universities are doing the same). For example, I always require students to use company’s “reported” financial statements, rather than the generalized statements from commercial databases. Accounting distortion adjustment is also an important part of their financial analysis and valuation project work. I am happy to say that more and more students start to appreciate the importance of accounting knowledge in financial analysis and valuation, although some are still reluctant to study accounting in depth.

Regarding the Apples-to-Apples comparison, I understand that neither IFRS nor USGAAP requires cash flow statement for the quarter. But in Singapore, the Singapore Exchange listing manual requires both the quarterly and cumulative cash flow statements. So it is easier to do quarterly comparison for Singapore companies.

Your class sounds like one that I would like to have taken when I was in graduate school. Well done! Also, I was not aware of the Singaporean requirement to have quarterly cash flow statements. That shows definite foresight on the part of your nation’s accounting authorities. Yea!

The mistakes in accounting about which you have told here are very harmful for business. Some accountant don’t take care about these because these are seeming very little but harmful on huge level. Accountants can get lots of knowledge to avoid these mistakes by the given detailed and useful blog.

I do believe that every good and valuable analyst must have accounting/reporting experience to understand all figures, its nature and relationships. This is my rule and it works without exceptions every time I meet an analyst

Business valuation depends on expected cash flows, not necessarily accounting. That’s why less attention is spent towards the accounting. However, we do agree with you, the analysis will become better if the accounting practices are correctly understood.

Thank you for your very kind words. It brings a smile to my face that you enjoy my articles : ) Much of the wisdom I accumulated as an investment manager I have shared here on Enterprising Investor, so I encourage you to review my archive on my author’s page to (possibly) learn more.

I am not sure which part of my article to which you are referring. I am guessing it is the last paragraph. Your comment is vague so I also need to infer what you were meaning. Probably, you are wondering how depreciation – a non-cash expense affects free-cash flows – yes? Normally, you would be correct but only after assuming the following:

1) That, as an accountant, you have the insider’s view of the financial statement. The analyst is a slave to what is reported, whereas the accountant is not. So you know the real number for actual depreciation, and you may have insight about how that number relates to actual economic depreciation.

2) That the depreciation is reported correctly and not fraudulently reported. The very point of my comment was that the company was playing games with the useful lives calculation (most likely fraudulently). Given that likelihood, that does affect your calculation of free-cash flow because depreciation is an add-back to free-cash flow. Garbage in, garbage out.

3) That depreciation, being a non-cash number, is not an economic number. As an investor in a business, the viability of the business as a going concern is crucial. If a company plays games with depreciation it has long-term free-cash flow ramifications because of its economic ramifications. Said another way, analysts do not have the luxury of single period calculations, we have to make assumptions about the future, too, and usually based on the information generated in our financial statement analysis. Is your comment anchored in a one-period evaluation? I am guessing so, or you would have understood the ramifications of a bad depreciation report on future free-cash flows more clearly.

4) Many analysts (and accountants, in my experience) in their free-cash flow calculation assume operating capex is the same as depreciation. Play games with depreciation and an analyst will be surprised when capex differs significantly from depreciation. Again, it is a half-truth that depreciation is a non-cash expense. It is a non-cash expense until the asset wears out and has to be replaced. And, again, you have to have a more than one-period view of the financial statements. Are you, as an accountant, mired in financial statement preparation for this quarter, until the next quarter needs to be prepped, until the next one, too? Are you simply noting things after the fact, and not thinking about future ramifications? It is my experience that accountants frequently misunderstand the interpretation of financial statements and their ramifications for the future value of a business because of their anchoring on past periods or, at best, the current period.

Thank you for your kind words. Ironically enough I did write such a book, but publishers told me that no one would buy and read such a book : ) Someday I might self-publish what I authored back in 2008.

This is an eye opener for me, newly joined Asset Manager for the 1st time as a credit analyst. I am using Bloomberg as my source data for financial statements, which is in good format for me but sometimes I have to consult the actual financial statements published by companies on their website to get detailed information.

Yes I agreed with this despite all of the warnings to pay attention to the information contained in footnotes, most analysts do not read them. Nor do most analysts take the numbers from the footnotes and put them into the main three financial statements.

More than 130 business leaders have responded to a deadlock in the UK Parliament by signing a letter calling for a second Brexit referendum to prevent a chaotic withdrawal from the EU. "The only feasible way to do this is by asking the people whether they still want to leave the EU," the letter says. CNBC (17 Jan.)

The Chinese government is likely to establish a growth target for this year that falls short of the 6.5% target set for 2018, sources said. This year's target is expected to be 6% to 6.5%. China Daily (Beijing) (18 Jan.)

CFA Institute is the global, not-for-profit association of investment professionals that awards the CFA® and CIPM® designations. We promote the highest ethical standards and offer a range of educational opportunities online and around the world.

By continuing to use the site, you agree to the use of cookies. more information

The cookie settings on this website are set to "allow cookies" to give you the best browsing experience possible. If you continue to use this website without changing your cookie settings or you click "Accept" below then you are consenting to this.